There are very few questions to which a politically acceptable answer in the chancelleries of Europe is “more investment banks”.

But as governments across Europe contemplate years of economic stagnation as public sector austerity collides with wholesale deleveraging, they may be forced – however reluctantly – to turn to the same investment banks that many of them blame for causing the crisis in the first place to help dig them out of it.

To complete the irony, investment banks are rubbing their hands in anticipation of a possible deluge in capital markets’ activity that would give even the most cold-blooded investment banker a hot flush.
The problem for Europe is simple: its economy has stalled and its banking system is paralysed.
European companies have traditionally relied far more on direct bank lending for their financing needs than their US counterparts, and European banks have relied far more on wholesale funding than on deposits to fund themselves. When this seizes up, everything grinds to a halt.

Despite a mini-boom in debt issuance this year and record low funding costs, corporate bonds account for just 15% of all non-financial corporate debt in the UK and euro area, according to S&P, with 85% made up by bank loans. In the US, the equivalent figure is 47% bonds and 53% loans. (As a warning, bonds account for just 16% of Japanese corporate debt.)

At the same time, what little lending capacity European banks still have is being put under severe strain by the well-intended reform of capital and liquidity requirements (designed to make banks safer), which is in turn raising the cost of lending for the banks and forcing them to reduce their leverage.

Political pressure

But as banks have cut their lending to hit new capital ratios (the International Monetary Fund expects the balance sheets of the biggest banks in Europe to shrink by $2.6 trillion or 7% through 2012 and 2013) they have come under intense political pressure to lend more.

As one bank lobbyist recently said: “It’s like having one government department telling you to lend more, and someone else in the same department telling you to lend less.”

You don’t have to be a clever bureaucrat in Brussels or a sharp investment banker to realise that if you suddenly turn off the taps, there will very soon be an acute shortage of funding. In a recent report, the Association for Financial Markets in Europe warned that this funding gap is wide and likely to get wider. It cited S&P research that over the next five years companies in the UK and the eurozone will have to refinance $9 trillion worth of debt and will need to raise an additional $2 trillion.

Even if you assume that the European capital markets can absorb the refinancing side of the equation – a big if – corporate bond markets would have to operate at twice the capacity of their best-ever year to meet this target.

Gaël de Boissard, the newly appointed co-head of the investment bank at Credit Suisse and chairman of Afme, said in the report: “We need a vision for developing deep and liquid capital markets in tandem with a restructured banking system.” He reckons that achieving the shift from reliance on the balance sheets of big banks to a greater focus on capital markets “would be a change to Europe’s financial system almost as profound as the arrival of the euro itself”.

Other bankers see it in more material terms. Goldman Sachs has described the disintermediation of financing in Europe as one of its biggest opportunities over the medium term, and the head of fixed income at one big Europe bank described it as “the biggest strategic opportunity for investment banks since the euro”.

The numbers could be eye-popping. Corporate bond markets in Europe would have to more than double to handle this capacity, with an accompanying surge in secondary and derivatives trading volumes. The high-yield market would have to triple from its already frothy levels to get to the same relative size as in the US. As the European market moved towards a US model, equity markets would have to nearly double to take them to the same size relative to the European economy as they are in the US; trading volumes would nearly triple.

If all of this sounds too good to be true, that’s because it probably is. A US-style capital market is not going to spring up overnight. Corporates will take time to cut the umbilical cord with their banks and many banks will continue to lend to clients at uneconomic rates rather than lose them (plenty of banks have been doing this for years). For the market to flourish, there needs to be demand from institutional and retail clients, many of whom are understandably suspicious of investment banks and the capital markets right now.

Dose of reality

But above all, there needs to be a conducive regulatory environment. And this is where the governor of the Bank of Finland enters stage left to pour cold water on all the excitement. Erkki Liikanen, in his recent report for the European Commission on the possible future structure of the banking industry, proposed that large banks be forced to ring-fence their trading operations. The thinking here was that if the trading business went sour, it would be cordoned off from the more important retail and payments business and could be shut down without triggering a crisis.

The problem with this proposal – at least from the investment banks’ perspective – is that ring-fencing the trading business would increase the costs of investment banks to such a degree that they would be unable to provide the sort of financing capacity that the above scenario suggests is needed in Europe. They argue that Liikanen’s proposals would undermine the depth and liquidity of the secondary market, which is an essential prerequisite for a healthy primary market.

On this reading, Europe has a problem. Investment banks and capital markets could be its unlikely saviour. But the Liikanen proposals – and so far they are only proposals – could be precisely the opposite of what is needed.

This argument may sound self-serving for the banks. But it explains why European banks are focusing almost all of their attention on Liikanen and have effectively stopped fighting other reforms such as Basel III or Vickers. This strategy assumes that banks will lend less – hey, they might even deliberately lend less just to prove their point. It also assumes that European politicians can be persuaded by the bankers that bigger, and not smaller, capital markets are the answer to everyone’s problems.